It's no secret that the cost of attending college has gone through the roof over the past few decades. A degree that could be earned for just a couple thousand dollars four decades ago can now require parents to take out a second mortgage on their house. Given this new reality, saving for your children's college education has never been more important.
But what vehicles should parents use when preparing for the day their kids leave home? There are lots of options out there, but the three most popular are 529 Plans, Roth IRAs, and Coverdell Education Savings Accounts (ESAs).
When it comes to the differences between these accounts, here's a view from 30,000 feet:
The most important thing for parents to know about 529 Plans is that every state has its own set of options for parents. However, you do not need to use the 529 Plan offered in your state, or the state where your child's future college is located. A California resident can invest in California's 529 plan ... or Oklahoma's ... or Ohio's. The options are almost limitless.
The key advantage to this is that this allows parents to shop around for the best plans with the lowest expense ratios. Last year, I dug through all of the plans offered in the U.S. The states whose funds had the highest returns with the lowest expenses were: Illinois, Kansas, New Mexico, West Virginia, Massachusetts, New Hampshire, Delaware, California, Rhode Island, Iowa, Maine, Missouri, and Alabama.
The drawback with investing in another state's plan is that you usually forfeit any state tax-related advantages. That being said, there's no federal break for 529 contributions, and state income taxes are usually far lower than federal ones -- so the benefits of such deductions can be limited.
In terms of investing for higher education, there are two main differences between setting up a Roth IRA for your child, and just investing the money in your own name in a non-tax-advantaged account.
The first is that the money is in your child's name, and such funds are not taken into consideration on FASFA forms -- though individual colleges may consider them when determining potential aid.
The second is that if there is any money left after your child has graduated, he/she can keep that as a nice start on their retirement savings.
Otherwise, this isn't any different than a non-tax-advantaged account.
If you are an experienced investor, I consider this the crown jewel of education savings. You get to choose how your money is invested, and all growth and withdrawals can be made tax-free -- assuming that the funds are used for qualified education expenses. Note that these can also include expenses for elementary, middle, or high school tuition and/or fees.
How my family uses these three
Because I spend my time writing for the Fool, I feel comfortable investing what money we can for our 3-year-old daughter's educational expenses. Every year, we max out her Coverdell account, and invest it in the most promising opportunities we can find.
After that, our dollars will go toward a 529 plan; though we haven't opened up an account yet, we will likely use an Illinois state plan -- as I have found them to be the lowest-cost plans around.
Every family's situation, however, is different. This should help give you a broad view of your options, but there is no replacement for reviewing them with your own financial advisor.
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